You've been retained as an analyst to evaluate a proposal by your city's privately owned water company to increase its rates by 100 percent. The company has argued that at the present rate level, the firm is earning only a 2-percent rate of return on invested equity capital. The company believes a 16-percent rate of return is required in today's capital markets.

Suppose that you agree with the 16-percent rate of return proposed by the company.

a. What factors need to be considered when setting rates designed to achieve this factor?

b. Would your analysis differ if you knew that individuals were prohibited by law from drilling their own wells? What impact would this have on the price elasticity of demand?

c. Water companies have a large proportion of fixed costs as compared with variable costs. How does this fact influence your analysis?